Tax Court decision on abusive DISC commissions to Roth IRA overturned
TAX ALERT |
On Feb. 16, 2017, the Sixth Circuit overruled the Tax Court’s substance over form determination in Summa Holdings Inc. v. Commissioner; No. 16-1712, 2/16/2017. Contrary to the Tax Court, the Sixth Circuit determined that the IRS overstepped its bounds applying a substance over form argument to claim a tax avoidance transaction when Congress created both domestic international sales corporations (DISCs) and Roth IRAs with the purpose of providing taxpayers the opportunity to avoid tax, provided the taxpayers followed the form of structures of the DISC and Roth IRA.
In Summa Holdings, Inc et al v. Commissioner, TC Memo 2015-119 (June 29, 2015), taxpayers set up a DISC to receive commissions on export sales from Summa Holdings and its subsidiaries. The DISC was owned by a C corporation holding company, which was in turn owned by two individuals’ Roth IRAs. The two individuals were also shareholders in Summa Holdings, and their father owned the majority of Summa Holdings.
The DISC was enacted by Congress in 1971 to stimulate U.S. exports through tax incentives. A DISC is a separate entity set up by a corporation that is allowed to receive a certain portion of export revenue and defer tax on that portion until the DISC pays a dividend to its owners. Under current law, the DISC restructure may allow not only for a temporary deferral of income recognition but also a rate disparity when that income is taxed because the corporation receives a deduction for the amount paid to the DISC at ordinary tax rates and the income is ultimately taxed at lower dividend tax rates.
Roth IRAs were enacted as a retirement savings vehicle, allowing taxpayers to set aside after-tax money currently and to withdraw the money, plus earnings, tax-free in the future. Contributions made to Roth IRAs are subject to income limitation thresholds and annual contribution limits. Dividends earned on investments held in the Roth IRA are not counted towards the contribution limits.
Although it is clear that both DISCs and Roth IRAs were enacted to provide certain tax benefits to their owners and beneficiaries, the Tax Court agreed with the IRS that the Roth IRA ownership structure was not related to those intended benefits, but rather was used only to shift income from a corporation owned by the IRA beneficiaries into their Roth IRAs. If the shareholders had taken dividends from the corporation in the same amount as from the DISC, the amount would have exceeded the contribution limitations for Roth IRAs so the DISC was used only as a means to take advantage of the exception for dividends earned on Roth IRA investments.
The Sixth Circuit acknowledged that this structure allowed taxpayers to build larger balances in the Roth IRAs than contribution limits might allow. However, the court ruled that “Congress created the DISC and empowered it to engage in purely formal transactions for the purpose of lowering taxes. And Congress established Roth IRAs and their authority to own shares in corporations (including DISCs) for the purpose of lowering taxes. That these laws allow taxpayers to sidestep the Roth IRA contribution limits may be an unintended consequence of Congress's legislative actions, but it is a text-driven consequence no less.” Ultimately, the Court said as long as the Roth IRA paid unrelated business income tax on the DISC dividends, as is also provided in the statute, then the taxpayers have lowered their tax liability in a manner that is allowed.
While ruling that the substance over form doctrine was not appropriately used in this case, the Court did acknowledge that it still has purpose in other instances when the economic realities of a transaction do not match the labels taxpayers give it. Nonetheless, the Court decided that the labels the Summa taxpayers used are consistent with the economic reality and with transactions that are addressed in the statute so the IRS is not correct to relabel them as something else. This decision, therefore, may end up having a larger implication for taxpayers and the IRS by reshaping the substance over form doctrine.